3/05/2010 @ 1:40PM

Beware The Carry Trade Collapse

The outlook for the economy in 2010 is dominated by debates in Washington, D.C., regarding what can be done to improve both the jobs and the growth picture. It is also being influenced by Congressional committee discussions of legislative remedies to prevent a recurrence of the abuses that caused the financial crisis.

What is unpromising about this is that it is not being perceived so much as a search for solutions as a search for political advantage. As a result, nothing is predictable. As a result, business and banking is marking time waiting for something to happen rather than trying to make good things happen. The problem with waiting for things to happen is that, more often than not, the happening is not for the better.

The president’s budget proposal promises to generate a trillion-dollar annual deficit for years to come despite there no longer being a financial crisis or deep recession. This represents not just a change in mindset about the role of government, but also an unsustainable financial situation that can only end in inflation.

Government can only issue debt so long as there are willing buyers at reasonable interest rates. This is so far being achieved by the Fed by keeping short-term rates artificially low so that banks and hedge funds can borrow at 25 basis points and use this money to buy treasuries yielding 3.5% to 4%. This is called the carry trade, and it is going on today on a massive scale.

The systemic danger of this carry trade activity is that it is done by institutions that leverage themselves by 10 to 30 times. This means they absolutely cannot afford to have long-term interest rates (which the Fed doesn’t control) go up. A rise in rates means the value of their holdings will quickly drop much more than all the interest they have earned on those holdings.

In short, at the first sign interest rates may rise, the carry-trade bubble will burst and everyone will rush to sell. Unfortunately the only big buyer for these treasuries will be the Fed–and given the state of its balance sheet, the only way it will be able to pay for them is by printing more money. That is when inflation will begin.

This carry trade bubble is around the $500 billion dollar level and growing. The bigger it gets, the more danger, since there is no foreseeable way for it to deflate short of bursting. A spike in long-term rates can be triggered by financial news, fear of new government regulations, an international event or even a rumor.

It is a fragile thread by which today’s economy hangs. When government intervenes with policies that are strongly driven by political considerations, the hopes for a positive outcome are slim. My message for 2010 is this: Take a defensive posture that anticipates an inflationary outcome. By the time you see actual inflation, it will already be priced into most financial securities.